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Why Not Tax Large Passthroughs as Corporations?

Most large profitable American businesses must pay the corporate income tax. Others are completely exempt from it. The unfairness of this is so plain even a 5-year-old can understand it. If that's not high enough authority for you, please consult the first commandment of tax economics: Thou shalt tax all business profits equally. If some competitors in an industry are exempt from corporate tax and others are not, the tax treatment results in inefficient excess investment for the fortunate and inadequate levels of investment for everyone else. There is also inefficiency across industries. If the apple industry is filled with tax-favored investors and the potato industry is not, there are too many apples and too few potatoes.

If this all sounds corny to you, fine. Forget we ever mentioned it. But don't come back later and want to talk seriously about corporate tax reform. The essence of reform is getting rid of loopholes -- hopefully to pay for lower tax rates. There is no better corporate tax loophole than complete exemption from corporate tax. If some big businesses can remain completely exempt from corporate tax for no good policy reason, the signal is sent. If the biggest beneficiaries from loopholes do not have to sacrifice, why should anybody else? This tax reform is not about principle. It is about power, so start flexing your muscles.

In his State of the Union address this year, President Obama told the nation he intended to reform the corporate tax. Given the logic of tax reform, taxing large passthroughs as corporations should be included in that effort. So it was no surprise when the Treasury Department revealed its interest in a plan that would tax passthrough entities with more than $50 million of receipts. And after all -- although given zero attention by the press, the public, and Congress -- the president's tax reform commission, chaired by Paul Volcker, did include such a proposal in its list of possibilities. "Many individuals with whom we met suggested that it was neither fair nor good tax policy for businesses of similar size and engaged in similar activities to face different tax regimes and different tax rates," the commission reported.

At a May 4 Senate Finance Committee hearing, committee Chair Max Baucus, D-Mont., chimed in: "We're going to maybe have to look at passthroughs -- say they've got to be treated as corporations if they earn above a certain income. It's one possibility." That sounds more like a trial balloon than the fighting words of a leader who wants to tackle a tough political issue. And given the Baucus big-talk-no-action track record, nobody should be expecting decisive action. Moreover, Baucus's counterpart in the House, Ways and Means Committee Chair Dave Camp, R-Mich., commented that the proposal was "not something I'd be inclined to consider."

Camp's disinclination subsequently got an important endorsement. Last week, former IRS Commissioner Larry Gibbs, now with Miller & Chevalier, said he thought Treasury's idea was "wrong-headed." It seems that Gibbs's chief problems with the proposal are its added complexity and his reluctance to add a second layer of tax to a sector paying a lot of individual tax.

In a town packed with good tax lawyers, Gibbs is one of the best. And when any former commissioner who has been on the front lines of tax administration speaks about complexity, we should pay careful attention. True, applying a new set of tax rules -- namely, corporate tax rules -- increases complexity for those that have never paid corporate tax before. But it isn't all a one-way street. Isn't partnership taxation one of the most complex areas of the tax law, and won't relief from those partnership requirements offset some of the new complexity? Potential investors in master limited partnerships are always warned that their taxes will become more complicated if they enter the market. Surely, fees paid to return preparers will decline if the preparers receive dividends instead of partnership distributions.

On increasing the scope of double taxation, the former commissioner has a point. After all, the corporate tax is our worst tax. Shouldn't the goal of any tax reform be to get rid of it? Especially when full individual tax is being collected on that income? If all businesses could get that preferential treatment, we would have to agree. True tax reform would completely eliminate the double taxation of corporate income. Short of that, we should reduce its effects across the board, not piecemeal. The causes of fairness and economic efficiency would be served by not allowing large businesses to escape corporate tax and using the revenue gained to relieve the double tax burden for all.

Table 1. Subchapter S Corporations With$50 Million or More in Receipts, 2008

Source: IRS, Statistics of Income division.

Again, this is the basic logic of tax reform: lower the rates and broaden the base. In some cases tax advantages can be justified if a business is generating positive externalities, as it might if it were conducting basic research or producing clean energy. Two of the industries that have the most to gain from continued exemption from corporate tax are oil and investment banking. Most of the 90 or so publicly traded partnerships fall into one of these two categories. It would be easy to make an economic case that these two industries create negative externalities and should, if anything, be treated more harshly than other businesses.

Reality Check

What should be the dividing line between businesses subject to corporate tax and those that should be exempt? That's not an easy question given that there is no economic justification for the corporate tax in the first place. Economics says it should be repealed. If there must be a second layer of tax on business, economics would push us in the direction of making all business income subject to the tax, with a low rate. That too is impossible because of America's veneration of small business. Given that immutable political constraint, we should avoid allowing large businesses to escape the tax, and we should not allow small businesses to pay a double tax when their large competitors do not.

Tables 1 and 2 show the extent to which large businesses escape the corporate tax. In 2008 slightly more than 4 million S corporation returns were filed with the IRS. The overwhelming majority of these were from small businesses. More than half of the S corporations had one shareholder. But there were 14,000 S corporations with more than $50 million in receipts. They accounted for 29 percent of all S corporation profits. Their average level of profit was $6.4 million. Other IRS data (not shown in Table 1) indicate that more than 8 percent of subchapter S corporation profits were earned by businesses with more than $250 million in assets.

Table 2. Partnerships With $100 Million or More in Assets, 2008

Source: IRS, Statistics of Income division.

In 2008 the IRS received 3.1 million partnership returns. Only about 18,000 of those returns -- 0.6 percent of the total -- reported assets of $100 million or more. But these partnerships, with an average of 300 partners, accounted for 64 percent of the profits of all partnerships. Average profit for this group was $16.2 million.

Table 3. Tax-Free Large CorporationsCompete With Taxable Small Corporations, 2007

Source: IRS, Statistics of Income division.

There is no obvious definition of small business. It's all a matter of judgment. Nevertheless, the data from tables 1 and 2 indicate that a significant portion of profits that escapes double taxation accrues to businesses that are not small by anybody's definition.

Table 3 demonstrates the unfairness and inefficiency of current law. Not only are large corporations avoiding corporate tax, they are doing so while smaller competitors in the same industry pay significant tax. Compare the last two columns of the table. The cohort of 339 manufacturing S corporations with an average of $429.3 million in receipts pays no corporate tax. Meanwhile, 801 manufacturing C corporations -- much smaller than their S corporation brethren, with an average of $99.3 million in receipts -- pay an average of $3.3 million in corporate tax. What policy purpose is served by taxing small manufacturers more than large manufacturers?

Follow the Canadians' Lead?

Our readers who work at large law and accounting firms need not lose any sleep over the ruminations in this article. Like the rest of corporate tax reform, the notion of taxing large partnerships and subchapter S corporations is going nowhere in the foreseeable future. If it does, the most likely targets will be publicly traded partnerships. In 2006, to raise revenue to pay for a corporate rate reduction, the newly elected conservative government in Canada put an entity-level tax on publicly traded oil and mining royalty trusts.

In 2007 Baucus and Finance Committee member Chuck Grassley, R-Iowa, introduced legislation that would tax as corporations publicly traded partnerships that provide investment advice. Then-Sen. Obama was one of the three cosponsors. The targets of this legislation were Wall Street behemoth private equity firms like Blackstone, Fortress, and KKR. The legislation went nowhere. Like the absence of a post-meltdown bank tax, and like the failure to end the preferential treatment of carried interest, the fate of the Baucus-Grassley bill demonstrates that even in times of unprecedented fiscal crisis, Wall Street is bulletproof.

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